Huber: Telecom undone-a cautionary tale

R. A. Hettinga rah@shipwright.com
Tue, 21 Jan 2003 11:07:07 -0500


Everybody who makes their living on the net or in finance should read this.

Below, Peter Huber shows how an entire industry -- and now the entire world
economy --  learned that you don't calculate prices, you discover them.

Cheers,
RAH
------

http://www.manhattan-institute.org/html/_comm-telecom.htm

The Manhattan Institute for Policy Research


Commentary

Telecom undone-a cautionary tale
January 2003

By Peter Huber

The demise of the telecommunications industry can be traced to a single
source-the FCC's own implementation of the Telecommunications Act of 1996.
Huber examines how utopianism and meddlesome arrogance on the part of the
government have resulted in the near-total collapse of the
telecommunications industry.

SELDOM has a chairman of the Federal Communications Commission (FCC) been
heard to anticipate the demise of the most important sector of the industry
he regulates. Yet in a speech to a Wall Street gathering in October,
Michael Powell, chairman of the FCC (and son of the Secretary of State),
summed up his view of the state of the nation's telecommunications
companies as follows: "Few are prospering. Few are growing. Few are
spending. Few are investing. The status quo is certain death."

Powell's biggest worry is the "wireline" telephone industry, which carries
most of the nation's data and voice communications. It accounts for the
lion's share of the industry's revenues-far more than broadcasting-and
supplies critical infrastructure for our entire information-centered
economy. Three years ago, this sector was seen as the epicenter of
innovation and profitable new investment. Today, it is in shambles.

The hundred-year-old Bell telephone companies, once the rock-solid
investment of choice for widows and orphans, are now in sharp decline. The
$65 billion poured into the market by their competitors between 1997 and
2001 is now worth under $4 billion. AT&T's stock, which peaked at $60 in
1999, stood at $8 last July. Lucent, the owner of Bell Labs and not long
ago the largest vendor of telecom equipment, has lost over 90 percent of
its value since January 2001; it has announced a reverse stock split to
escape delisting on the New York Stock Exchange. Nortel, its main rival, is
in even worse shape. To top it all, antitrust trial lawyers have vowed to
turn the older local phone companies-which are the few remaining pockets of
solvency in the industry-into (in the words of one legal observer) the
"next asbestos or tobacco companies."

Of course, the rest of Wall Street has had its troubles, too-but the
collapse of the telecom sector may be what dragged it down. Information
technology (IT) delivered about two-thirds of the rise in labor
productivity in the last half of the 1990's. Circuit designers, chip
fabricators, software companies, and many other elements of the IT economy
now depend on new investment and innovation in the telecom sector. In an
industry that has historically accounted for between $50 and $150 billion
dollars of capital investment every year, capital spending has plummeted.

The telecom collapse is now often chalked up to several years of irrational
exuberance on Wall Street, together with accounting fraud by WorldCom, one
of the industry's leaders. But-as Michael Powell, for one, appears to
recognize-there is a serious case to be made that the industry's refractory
problems can be traced to a single source: the FCC's own implementation of
the Telecommunications Act of 1996. Thereby hangs a most dismal tale.

THE LAST time Congress enacted a telecommunications law of comparable scope
to the 1996 act was in 1934, when it created the FCC itself and codified
the core policy of maintaining telephone companies as regulated monopolies.
The 1996 act, passed by wide majorities of both houses of Congress and
signed by President Clinton with great fanfare in the Library of Congress,
was intended to do just the reverse: to open telecom markets fully to
competition, and to deregulate them.

The job of deregulation had been started in 1984, when the courts split the
old Bell System into its local and long-distance components. The decision
left the local phone companies, which account for the majority of
telephony's networks and revenues, to their "natural monopolies," barring
them from entering other markets. Only on the long-distance side was
competition opened up to new carriers and an emerging family of "online
service providers," the companies we now know as dot-coms and Internet
portals.

By 1996, it had become clear that this upstairs/downstairs division of the
industry no longer made sense. Wireless services were booming. Cable
companies were upgrading their networks to provide high-speed local
connections to the web. Long-distance carriers were poised to invest tens
of billions of dollars in new fiber-optic networks snaking through business
districts in Manhattan, Chicago, and other major urban markets. E-mail, web
pages, and other data services were beginning to offer distinct but
nevertheless competitive alternatives to local voice calls. And local phone
companies were clamoring for permission to extend their networks and
businesses into long distance, video, and data.

One might suppose that the way to open an industry to competition and
deregulate it is to do just that. In the early 1980's, that is pretty much
how trucks and airlines were deregulated. But, for reasons that seemed
sensible at the time, the 1996 act proceeded differently.

It started in the right place-telling states they could no longer forbid
competition in local phone markets and outlining a process for admitting
local companies into long-distance markets, state by state. The latter
process, however, was tied to the development of a new body of regulation.
Existing (or "incumbent") local companies would be required to
interconnect, on reasonable terms, with their upstart competitors, and also
to provide nondiscriminatory access to such things as 411 databases. The
reasoning was that nobody would sign up for a new phone company's service
if the new network were unable to place and receive calls to and from the
old. In addition-crucially, as it would emerge-incumbent local phone
companies were required to "unbundle" parts of their existing networks and
lease them to competitors at wholesale rates. This would allow the
competitors to get a foothold without having to replicate every last wire
and switch from the get-go. In other words, unbundling would lower the
costs of competitive entry.

But the 1996 act did not specify just how much unbundling was to occur;
this is something the FCC was expected to work out later on. The single
guideline in the act stipulated only that, before defining an "unbundled
network element," the FCC should "consider" whether competition would be
"impaired" without it. As to what these elements were worth-their wholesale
prices-the FCC was told in equally cryptic terms that this calculation was
to be "based on cost."

ENTER NOW the human element. In 1996, the man ensconced in the chairman's
office at the FCC was Reed Hundt, an old and trusted friend of Vice
President Al Gore. The two had been boyhood buddies at St. Albans, a prep
school in Washington, D.C., and Hundt had advised Gore on his two Senate
campaigns, his 1988 presidential campaign, and his 1992 run with Bill
Clinton for the White House. Neither Clinton nor Gore ever bothered to
interview Hundt for the FCC chairmanship. Clinton had handed telecom to
Gore, and Gore handed it to Hundt.

Hundt was already in the third year of his tenure when the new act became
law in early 1996. Up until then, his main focus had been on wireless
services, where he had already orchestrated some dramatic changes that were
a harbinger of things to come. Although something of a digression from our
main concern, that story is too pertinent to ignore.

In 1993, the same year in which it confirmed Hundt's appointment, Congress
had for the first time authorized the FCC to auction off licenses for radio
spectrum. Such auctions, the reasoning ran, were the most efficient way to
go forward, and would allow the wireless industry to get on swiftly with
building its towers and rolling out service. Hundt proceeded to sell off a
slew of new licenses. For a vigorous young administration committed to
reinventing government, it made for a wonderful photo-op when he was able
to go to the White House to present a symbolic check for $7.7 billion to
the President.

But it turned out that Hundt had also embellished the new auction rules
with many-too many-preferences, bidding credits, and low-interest loans.
Successful court challenges delayed several of the auctions, and while the
bidding went sky high, much of what was bid was never ultimately paid. The
most costly misadventure was launched in 1995, when Hundt sold almost $5
billion of radio spectrum to a company called NextWave in an auction
reserved for "small businesses and other designated entities." Hundt had
neglected to make sure that the small and the designated were good for this
kind of money; they were not. In due course, the FCC would reauction the
same spectrum for $16 billion, NextWave would sue, and the wireless
industry would find itself under a cloud of $21 billion of liability, with
no usable spectrum to show for it. The issue is still unresolved today, and
a huge block of idle spectrum still hangs in the balance.

While Hundt was conducting wireless auctions, Congress was drafting the
1996 Telecommunications Act. As soon as it passed, the industry began to
learn the new meaning of "unbundling." It was unlike anything that had
occurred before.

There was a day, remember, when you either leased your phone and your
telephone line together, from the one and only phone company, or you did
not lease either one; the freedom we enjoy today to buy our telephones and
modems separately from Radio Shack or Dell can be traced back to unbundling
rules that were put in place in the 1960's. Then came the 1984 break-up of
AT&T, which forced a similar unbundling of local and long-distance services.

The unbundling required by the 1996 act was rather different. It was to be
a wholesale unbundling of a wide variety of "network elements," and the new
elements thereby created were to be leased not to consumers but to
competitors. Admittedly, it made a kind of sense. If you live in an
apartment on East 87th Street in Manhattan, you really have no interest in
leasing a mile of "unbundled" copper loop leading to Verizon's
fortress-like central office near the corner of 97th and Lexington so that
you can then drop in at Radio Shack to buy a ten-milliondollar telephone
switch and all the rest of what it takes to transform a wire into a
functioning dial tone. But a long-distance company might well opt to do
just that, using its own switches and operators to provide the rest of a
service package.

What would this mean from the standpoint of government regulation? The old
unbundling had shrunk the effective scope of such oversight: the regulated
phone company sold you less, so the regulator had less to regulate. The new
would apply a new layer of wholesale-price regulation to as much of the
network as the FCC chose to unbundle. Some $300 billion of assets, with a
depreciated book value of almost $150 billion, could now be put up for
sale, in pieces and at prices to be determined by one of Al Gore's oldest
and most trusted friends.

ISSUED JUST four months after the passage of the 1996 act, Hundt's rules
unbundled absolutely everything. The $25 electrician's box on the outside
wall of most houses, where the phone company's lines connect to the inside
phone wiring. The loop that runs to the central office. The switching
equipment and software in that office. The high-capacity fiber-optic lines
that connect local offices to the long-distance network, along with
operator and directory-assistance services. And more-much more.

Astonishingly, the new rules also required incumbents to offer all the
unbundled elements as a single re-bundled package-at the new wholesale
rate. New entrants, in other words, would not have to build a single new
item or a single new inch of network themselves if they did not care to.
They could compete simply by placing a new label on the facilities that
they had requisitioned, customer by customer, from the old phone company.

No less astonishing were the prices of Hundt's unbundled elements. They
were tied not to what it had actually cost to build things but to models
that predicted what it would cost a perfectly efficient competitor to
rebuild them from scratch, using the latest technology at the latest
prices. In an industry characterized by rapid innovation and inexorably
falling prices, the models thus effectively wrote off about half the book
value of the existing investment.

A competing phone company can now lease from Verizon, in perpetuity, an
unbundled copper telephone line from an East 87th Street apartment to the
basement of 97th-and-Lexington for about $15.50 a month. It can also lease,
at regulated rates and for as long as it may wish, a cage in Verizon's
basement to house any equipment it might care to connect to the line.
Switching service will run the new company $5 a month. Caller ID-which
Verizon itself would sell to ordinary customers for $8 per month-will cost
just twenty cents at wholesale. The prices are different in upstate New
York, and different again in Kansas (where, above the corn fields,
unbundled copper costs $23 a month). Nationwide there are many thousands of
discrete prices for unbundled elements.

As Hundt would later explain, he intended to write rules that would "cause
a flood of new investment and innovation that would wash away the
advantages of the incumbents-and erode their market capitalization." Many
would-be competitors enthusiastically supported that plan, as did their
financial backers on Wall Street. Competition was going to develop quickly,
and would soon be very profitable.

In the meantime, the one thing that was really growing was the regulatory
enterprise. Regulating networks inch by unbundled inch required much finer
oversight than regulating them by the bundled mile; setting prices by means
of computer models required much keener judgment than setting prices on the
basis of historical costs. In short order, the FCC added over 10,000 new
pages to the Federal Register.

In the summer of 1996, Hundt attended the Democratic National Convention,
seated in the Vice President's box. Gore's acceptance speech promised
Internet access for every classroom. As Hundt has recalled the occasion,
"the FCC, perhaps for the first time in history, drew extended applause
from a political party's nominating convention." The following year, with
the new rules largely worked out and Clinton-Gore safely reelected, Hundt
resigned from the commission, a year before his own term as chairman was to
expire.

WHAT WENT wrong? In early 2000, just before the crash, Reed Hundt published
a book entitled, You Say You Want a Revolution: A Story of Information Age
Politics. Reflecting the financial euphoria that still prevailed as he was
writing it, Hundt's book is a recklessly candid, self-congratulatory
account of what he did and why he did it in his nearly 48 months as FCC
chairman. In hindsight, it makes for a devastating self-indictment.

The passage of the 1996 act, Hundt writes gleefully, offered "the chance of
a lifetime." A Republican Congress had authorized a timid blueprint for
incremental change in the information sector, but what the country really
needed was a revolution. By means of his unbundling and price-setting
rules, and in company with Al Gore and "an eclectic set of other political
allies," he was going to help shape the new economy of "high growth, low
inflation, productivity gains, and explosive entrepreneurial enterprise."

Economists on the FCC's staff warned that if wholesale prices were pushed
too low, the stock market would be prompted "to sell off the Bell stocks,
[and] bring the Dow crashing down." But Hundt was confident he could
calibrate things just right. And he knew he was succeeding because "Bell
stocks rose during our deliberations." Hundt's Democratic champions in
Congress, Edward J. Markey and Fritz Hollings, gave him the cover he needed
to forge ahead. For their part, the Republicans left him alone because they
were sedated by the rising stock market.

By the end of 1999, according to Hundt's estimates, some $30 billion had
been invested in the new enterprises made possible by his rules. There were
hundreds of new local phone companies of various kinds, along with many
dozens of new local carriers of data. Nine of the latter had gone public,
or were about to do so.

Nobody was bankrupt in 1999, of course-but then, nobody had yet found out
what Hundt's rules really meant. At that point, the lift in the telecom
bubble was still coming from the promise and not the actuality of what the
rules would deliver. The regulatory blueprints written by Hundt had to be
implemented by state commissions and cleared through state and federal
courts; that process did not go quickly.

Indeed, it was in large part because of all this back-and-forth between the
agencies and the courts that the regulatory decisions Hundt made in 1996
and 1997 did not begin to have any real impact on the market until several
years later. (Nearly 80 percent of the transfers of unbundled elements have
occurred only in the last 24 months.) By then, Hundt himself had joined the
party. Very soon after he left the FCC in 1997, he was advising or on the
boards of Allegiance Telecom, Ascend Communications, Brience, CoreExpress,
eYak, Global Connect Partners, Phone.com, and Sigma Networks, among others.
Reportedly he made over $15 million on stock options received for his
services, including millions of dollars of stock in NorthPoint
Communications that he cashed out just a few quarters before NorthPoint
filed for bankruptcy.

WALL STREET itself completely failed to grasp what Hundt's rules entailed,
at least until the economic impact finally began to show up on the bottom
line. Only then did the markets come to understand that something had gone
terribly wrong. Since then, telecom stocks have been in freefall-- and not
just some telecom stocks, but all of them. To understand why that should be
so, one must consider how Hundt's rules look from the perspective of each
major group of players in the industry.

Let us start with the incumbent phone companies, the principal targets of
Hundt's unbundling. Every inch of their networks now has two prices. Retail
prices-what the companies can charge to consumers-are still regulated, as
they have been for the better part of a century, under schemes that are
generally pegged to actual historical costs and that subsidize rural and
residential users at the expense of urban and business users. Wholesale
prices-what they can charge competitors-are regulated by Hundt's models,
which look to future costs and which are not supposed to subsidize anyone.
The upshot is that, for the exact same service, wholesale prices are
sometimes lower than retail prices, and sometimes higher. Ordinarily,
imperfections in the price-regulating machinery tend to cancel each other
out; here, competitors buy wholesale where wholesale is cheaper than
retail, and consumers buy retail where retail is cheaper than wholesale.
One way or another, incumbent companies end up with sharply lower revenues.

But the regulatory impact is perhaps even worse for the new investors, who
(one might suppose) should be making out like bandits. The trouble is that
the serious ones have been building real, competitive networks, mile by
mile, for many years-in fact, since well before 1996. Some have been
running their own fiber-optic networks to reach large business customers in
urban markets-WorldCom and AT&T, for example, spent some $25 billion to
purchase two such companies in 1996 and 1998. And cable operators have been
aggressively upgrading their own wires to provide both voice and highspeed
digital channels. Thanks to Reed Hundt's computer models, however,
competitors with real networks-and real liabilities-are now squared off
against network-free competitors, and have found their stocks downgraded as
a result.

And what about those network-free competitors themselves? Take a company
like Z-Tel, founded and run by lawyers, bankers, management consultants,
and an antitrust litigator. Such companies have brought to telecom the same
talents that Enron brought to electricity. They build networks out of
paper, and whatever actual money they invest is poured into complex
software and computer systems developed and optimized for playing the
regulatory game.

A big problem with running paper networks is that any number of others can
play the same game. If there is any margin in this line of business, the
competition quickly makes it razor-thin. And it may be razor-thin in any
case: rebranding someone else's network as your own turns out to be an
expensive proposition, and the cost of inserting a new middleman between
the network and the customer often swamps even the ruinous discounts that
regulators have imposed. (Z-Tel claims to have invested more than $100
million to create an interface with the incumbent phone companies, and
perhaps it has.) As a consequence, many would-be Z-Tels-- there were
hundreds of them at one point-have already landed in the financial dustbin.

As I say, all this took a while to work itself out. When Hundt testified
about telecom's woes last October before the Senate Commerce Committee,
almost his very first words were that it had been five years since he had
left office. If the telecom industry was in a shambles (the implication
was), it had not happened on his watch.

WILL REGULATORS ever recover their sanity and incinerate Hundt's rules? At
this point, that will be more difficult than it sounds. Some nine million
customers are now being served with re-bundled packages of unbundled
elements, and both sides have a stake in the status quo. Besides, even if a
decision were made to curtail unbundling sharply, it is hard to imagine it
happening quickly, or things ever being taken back to where they ought to
have started. The harried Michael Powell is now overseeing a major review,
but fundamental changes in so large a regulatory system take years to
implement and fight out in the courts.

The 1996 act could be amended, and the new Congress might conceivably do
just that. The Senate Commerce Committee will now be headed by John McCain,
one of only five Senators (and the only Republican) to have voted against
the 1996 act. But in its six years of operation the act has so sharply
divided the interests of telecom carriers that one cannot easily imagine
how a coalition could be formed to bring about a change of direction.
Climbing out of this quagmire will be far more difficult than sliding into
it.

In the meantime, as Hundt's rules meander back and forth through the
federal courts and the FCC itself, the center of action has shifted to the
state commissions where they are actually implemented. In a handful of the
most influential states, most notably New York, California, Texas, Ohio,
and Illinois, ambitious regulators-mini-Hundts-see little to lose and much
to gain by pushing wholesale rates lower and lower. In the near term, the
spoils of regulation can be spread around to create more friends than
enemies.

Most ominously of all, the trial lawyers are now circling the regulatory
road kill. Countless failed enterprises and disappointed investors are
searching for someone to blame. They cannot sue Hundt, or his computer
models, or the state commissions that now run those models; they can sue
the still-wealthy companies that own the legacy network. So the plaintiffs'
trial bar-the most loyal, aggressive, and well-financed interest group in
the camp of the Democratic party-is now litigating to transform Hundt's
rules into treble-damage antitrust suits. Some thirty-six such suits have
already been filed.

Is there any basis to them? WorldCom, Z-Tel, and others have undoubtedly
encountered many problems as they have labored to build new businesses out
of unbundled network elements, but certainly no worse problems than those
faced by the incumbent phone companies that they or their customers are now
suing. Implementing Hundt's rules has been a logistical nightmare all
around. Tens of billions of dollars have been spent to facilitate the
transfer of tens of millions of elements from old companies that built them
to new companies that want them. The incumbents have certainly fouled up in
their scramble to comply with the new rules; the competitors have fouled up
even more in administering their side of things, and in more than a few
documented instances they have deliberately falsified their records in an
attempt to shift the blame. Thrashing out these issues between carriers has
been difficult enough; the antitrust suits now raise the stakes enormously.

Just what the courts will do with the suits remains entirely unclear. Two
years ago, a federal appellate court in Chicago held that Hundt's rules go
well beyond the antitrust laws; the 1996 act has its own enforcement
structure, centered in the FCC and state regulators. This June, however, a
second ruling by the federal appellate court in New York held just the
opposite. It will take several more years to determine whether Hundt, an
antitrust lawyer himself before he landed at the FCC, has indeed transmuted
the law of telephones into the law of tobacco. If he has, the torch will
have been passed-from Al Gore, to Reed Hundt, to the class-action
racketeers.

AT THE end of this depressing tale one is still left wondering: how do
generally rational and responsible people create such a gigantic mess?

There is no hint of outright corruption in this history, though there is
something distinctly malodorous about an FCC chairman prospering so
handsomely, and so quickly, when he signs up to help companies exploit the
rules he wrote just a few months earlier. No, in the end the failure of the
1996 act reflects corruption of a different kind, a corruption of political
culture.

Hundt was a Clintonite who eagerly embraced the Clintonite ethos. Exuding
confidence, daring to be bold, he was a man in a hurry, impatient with the
plodding engineers who build real networks. So his rules set prices based
on models rather than on experience, and allowed new entrants to assemble
new networks entirely on paper. All you had to do to compete in Hundt's
village was to buy low and sell high. Potemkin could hardly have done it
better.

But all this quick and painless competition required a stupefyingly complex
labyrinth of rules. Such rules regulated the price of everything, not once
but twice; they suppressed competition rather than promoting it; and they
enriched no one but legions of lawyers (like me), plus accountants,
economists, and still more legions of expert witnesses for hire. It was
Hillary-care for the telecom industry, but better, since with it came the
added conceit that this all-consuming regulation was just a stepping stone
to-deregulation.

Tellingly, two of the strongest critics of Hundt's legacy have been
Democrats of the old deregulatory school-in fact, the two men who
orchestrated the deregulation of trucking and airlines two decades before
Hundt took on telephones. They are Supreme Court Justice Stephen Breyer and
Alfred Kahn, who chaired the New York Public Service Commission and later
the Civil Aeronautics Board as it was being dismantled. Kahn has referred
to Hundt's pricing rules as TELRIC-BS. TELRIC is the FCC's own acronym for
Hundt's scheme-it stands for "total element long-run incremental cost." The
BS is Kahn's codicil, which (he pretends to insist) stands for "blank
slate": prices based on forward-- looking computer models rather than
historical books of account.

Could it have been done differently? A less ambitious and more patient man
than Hundt would have unbundled much less. In two separate cases, the
Supreme Court and three appellate judges have since concluded that that is
what the 1996 act required him to do. A more modest and patient man would
also have linked prices to actual rather than theoretical costs. As Justice
Louis D. Brandeis argued in a 1923 opinion about the telephone industry,
tying price regulation to monies actually spent in the past anchors prices
in solid reality. By contrast, forward-looking models of what things ought
to cost in the future are unanchored to anything and can quickly lose touch
with reality, especially when yoked to a wildly misplaced confidence in the
power of a federal commission to reallocate several hundred billion
dollars' worth of assets for the better.

AND THAT is pretty much the whole story: utopianism and meddlesome
arrogance, both empowered by government. The telecom bubble of the late
1990's rose alongside the dot-com bubble because, like web programmers,
regulators convinced many people that they could conjure up competition and
wealth out of thin air. And behind this delusion lay politics-politics in
the sense of public policy, and politics in the ruder, partisan sense as
well. In fact the two were inseparable. As Hundt himself revealingly
comments about a particular set of broadcast rules that he engineered: "we
were helping the President and Vice President win reelection."

Hundt was in the room the day after the 1992 election when the new Vice
President-elect huddled with his closest advisers in Little Rock. "Al
grinned at us and said, `Now we're running the White House. This is going
to be fun.' We all laughed. . . . We would slay enemies, reward friends,
celebrate victories, and find out what the Navy stewards served at the
White House mess." So they did. Reed Hundt was Al "Information Highway"
Gore one step down in the federal bureaucracy, where the policy work does
not just talk of reinventing government, he publishes 10,000 new pages in
the Federal Register, sets the stage for decades of destructive litigation
in the courts, and transforms a cautiously phrased law into a death warrant
for a vital industry.

PETER W. HUBER is a senior fellow of the Manhattan Institute and the
co-author of Federal Telecommunications Law. His contributions to
COMMENTARY include "Guns, Tobacco, Big Macs-and the Courts" (June 1999) and
"monopoly.com" (April 2000). Mr. Huber is also a partner in a Washington,
D.C. law firm that represents a number of telecom clients, including
several Bell companies.

-- 
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R. A. Hettinga <mailto: rah@ibuc.com>
The Internet Bearer Underwriting Corporation <http://www.ibuc.com/>
44 Farquhar Street, Boston, MA 02131 USA
"... however it may deserve respect for its usefulness and antiquity,
[predicting the end of the world] has not been found agreeable to
experience." -- Edward Gibbon, 'Decline and Fall of the Roman Empire'